Fed: Awaiting Yellen

Published on June 6, 2016

After Friday’s unexpectedly dismal Non-Farm Payroll print, there is going to be an even greater than usual parsing of Federal Reserve Chair Janet Yellen’s lunch time speech today on the “Economic Outlook and Monetary Policy.”

*** We expect Chair Yellen to acknowledge the disappointment in Friday’s NFP and the need to see further data to discern any break in the cumulative labor market gains. But while she is going to be characteristically cautious and careful in her language, we think she will defend the policy normalization strategy and, in effect, keep a July rate move on the table while by default extending an appropriate rate move “in the coming months” to September if the clarity in the data is still lacking by mid-summer. ***

*** What’s more, we expect any such near term rate move will invariably be a “dovish hike,” coming against what is likely to be another marking down in the projections for the 2017 and 2018 rate hikes as well as the longer run neutral rate, due to lower trend growth and the persistence of the very low neutral rate (SGH 5/4/16, “Fed: Burden of Proof”). ***

Cumulative Labor Market Gains

To be sure, Chair Yellen is all but certain to acknowledge the disappointment in Friday’s NFP and the need to see further data to discern any potential break from the previous trend of employment gains.

But she is also likely to point to broader data, like the recent robust retail sales, firmer housing data, and the upward revisions in first quarter and second quarter GDP estimates, that are lending to the Fed’s confidence in the forecasts for above trend growth, a steady tightening in the labor market, and slowly rising inflation.

And we expect her to note the need for a cautious policy approach amid the outlook uncertainty, but we likewise think she will still reaffirm the likelihood of an a very gradual pace of rate increases going forward.

Indeed, in an echo of her San Francisco speech a little more than a year ago, she may note that pace could slow or speed up, be punctuated by extended pauses, or even reverse over the long arc of a gradual policy normalization set by a data-dependent path.

We expect Chair Yellen, in other words, to provide a fairly robust defense of policy normalization, that it is prudent for the Fed to begin probing for the equilibrium or neutral policy rate by slowly nudging rates up when so near the twin mandates on employment and inflation, invariably followed by an extended pause to gauge its effects on market pricing and the real economy.

But to wait for either, and especially inflation, to be clearly pushing past mandate-consistent levels would risk the need to move rates more rapidly, and would entail far too much risk in either causing a severe dislocation in markets unable to adjust quickly enough or overshooting the neutral real interest rate and derailing the recovery.

The risk management caution, in that sense, can cut both ways, in waiting too long and not just in moving rates too soon.

Chair Yellen may also put a more optimistic spin to note the lackluster productivity growth that is weighing on economic growth. It may at least in part be cyclically-driven in the strong dollar and weak oil prices that were previously slowing the highly productive manufacturing and energy sectors relative to the growth in the slow productivity service sectors.

That trend may now reverse with oil prices pulling away from the “financial tipping point” she worried about in March, and with the dollar no longer appreciating as sharply now that the Fed has readjusted the projected pace of its rate hike path.

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